Was the solution as simple as providing liquidity?

The Chart of the Week shows the components' contributions to US economic growth. Quarterly real GDP growth may be the strongest since a year, but headline figures may appear stronger than underlying GDP growth actually is.

United States

• Following some weeks in which US macroeconomic data were encouraging, last week was more of the same. Although we don't think that this improvement in economic data is sustainable, there has been a remarkable turnaround in expectations about economic growth prospects since last summer.
• In Q4, growth is expected to be somewhat stronger than 2%. Consequently, some expect strong growth for the rest of the year as well. On the contrary, we still expect only modest economic growth in 2012. Admittedly, business surveys picked-up, but the national ISM indices do not indicate that growth momentum has improved sharply, while non-farm payroll growth has been modest so far (around 100-150k per month on a 3 month average basis, with the exception of December.
• As such, the recent improvement in macroeconomic data doesn't provide enough reasons to expect stronger GDP growth than our earlier published estimate of 1.4% on average. If our expectations become reality, concerns of financial market participants about the weakness of the economy will likely pick-up again. Consequently, that would be a period in which QE speculation will probably pick-up again.
• This week's US economic agenda will be dominated by the FOMC meeting. As we discussed two weeks ago, the Fed announced that it will change its communication strategy to improve transparency in this week's meeting. By increasing transparency, the Fed has more possibilities to affect market expectations, but we expect mainly short-term market expectations to be affected by the projections. We expect the Fed's fund rate to remain at current level until the mid-2014 at least. Remarks about the balance sheet will thus be more interesting at this point in time.
• Something else that we should expect on Wednesday is an explicit target for the inflation rate, and possibly also for the unemployment rate. This would give market participants some additional 'tool' to judge when the Fed will start tightening monetary policy.
• Overall, the FOMC statement, the projections and Bernanke's press conference will give us more insights about the Fed's intentions. We will be watching closely every word about additional support to the housing market as this may signal that the Fed will announce the purchase of mortgage-backed securities sooner than some expect, despite the tentative improvement in the economy and housing market.

Euro zone

• All concerns about the euro zone's debt crisis seemed to have vanished last week. Is the whole crisis than just based on sentiment and was the solution as simple as just providing plenty of liquidity to banks? We don't believe that it is as simple as that. Admittedly, interest rates have fallen and sovereigns are therefore able to finance themselves against acceptable interest rates.
• On the other hand, enormous amounts of bond auctions are still expected. As such, (re-)financing risks have not abated. And that is not all, as the Italian economy has likely fallen in recession, which will make it hard to reduce fiscal deficits and convince market participants that all will be fine eventually. In other words, the fundamental problems remain despite that funding costs have eased somewhat.
• But it is not only Italy that is still at risk despite lower borrowing costs. Spain has successfully issued a number of bonds and therefore significantly reduced the amounts it has to raise this year. In addition, the new LTRO may help to ease short-term funding pressures further. Nonetheless, Spain is not there yet as the economy is in recession and there is a risk for negative surprises from the regions.
• Interestingly, data from national central banks show that commercial banks from these two countries (Italy and Spain) have increasingly made use of the ECB's tenders. Especially Italy has made use of the ECB's LTRO facilities (including the 3-year's LTRO), while also the total amounts that Spanish banks borrowed from the ECB jumped by about EUR 34bn. These are clearly huge amounts that will likely have supported the bond markets. It seems reasonable to assume that the next 3-year LTRO at the end of February will have a similar effect.
• On the other hand, banks borrow the money from the ECB after posting collateral and we are not convinced that this 'game' can go on for a prolonged period. Evidence for this may come from Greece as Greek banks have started to borrow less directly from the ECB. The big question is whether this is because Greek banks are running out of eligible collateral? This might be the case, especially as one takes a look at the deposit flight out of the country, which is just horrifying.
• Although a PSI deal will imply losses and possibly aggravating the problems of Greek banks further, the Greek probably hope that some form of PSI accord will be finalised soon as foreign capital will probably be needed to support the banks given that a nationalising with Greek money is no option.
• The focus will be on the EU finance ministers' meeting in Brussel, and also discussions about the Greek PSI will continue to attract attention this week. In addition, a number of downgrades by Fitch are expected at the end of this week or early next week.

United Kingdom

• Last week, we discussed the safe haven status of the UK, which is out of whack with fundamentals in our view. Despite ultra low government bond yields, spreads remain wide. A steep yield curve should typically be positive for the creation of money/credit expansion and this might therefore become a catalyser for economic growth. In this very slow recovery, however, there is not much appetite for increasing debt levels further from already elevated levels.
• As we expect an increase in the Asset Purchase Facility next month, it is worth taking a step back and discuss what quantitative easing has done. One can argue that QE and low policy rates have helped lowering market interest rates, while a credit crunch has been prevented so far. In addition, consumer and business confidence recovered in 2009/2010.
• Unfortunately, QE has not been as successful as the above words suggest. Confidence has fallen back after a brief recovery period and economic growth has been one of the weakest in the developed world. It seems that confidence indices in the UK have been mainly affected by global developments in that period, but this has hardly been translated in economic activity
• In our view, not inflation, but mainly economic growth and labour market conditions are the main explanatory variables for the BoE's monetary policy. As long as economic activity disappoints, the BoE will probably keep its monetary policy loose as its members hope that inflation will drop towards the target rate.
• Overall, QE has probably lowered market interest rates, but it has done little to boost economic activity. We expect also no significant boost from new rounds of QE on economic activity going forward.

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